Real Exchange Rate Persistence in US Dollar PPP Systems

Abstract

Abstract Persistent deviations of exchange rates from equilibrium values may lead to inefficient resource allocations internationally. Such persistence is well documented and represents a challenge for policy makers. If the source of the persistent deviations is real then effective policy interventions are limited. However, effective policy responses are possible when deviations are caused by nominal or market‐structure shocks. The appropriate policy response depends on the cause of the disequilibrium. In this study I use a structural vector autoregression to identify the shocks responsible for purchasing power parity (PPP) deviations for 12 US dollar exchange rates. I find that aggregate demand shocks are not the primary cause of PPP deviations. Real shocks and foreign exchange shocks are much more important. Foreign exchange shocks dominate exchange rate behaviour. This suggests a policy response with greater focus on the foreign exchange market and the degree to which persistent PPP deviations represent compensation for risk‐bearing or a form of micro‐structure inefficiency.

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